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December 2011

Instruments of macroprudential policyA Discussion Paper

December 2011

Instruments of macroprudential policyA Discussion Paper

Prepared by Bank of England and Financial Services Authority staff

The FPC would welcome comments on this paper. Comments should be sent by 10 February 2012 to: Victoria Saporta Head of Prudential Policy Division Bank of England Threadneedle Street London, EC2R 8AH Or by email to:

This paper was finalised on 20 December 2011. Bank of England 2011 ISSN 17544262

Background information on the FPCIn June 2010, the Chancellor of the Exchequer set out a plan for fundamental changes to the system of UK financial regulation. In July 2010 and February 2011, the Government published consultation documents on the proposed changes, and in June 2011 published a White Paper(1) outlining further steps towards the legislative enactment of the Governments proposed regulatory framework. The proposed reforms include the establishment of a Financial Policy Committee (FPC) charged with identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system. In February 2011, the Bank of Englands Court of Directors created an interim FPC to undertake, as far as possible, the future statutory FPCs macroprudential role. It also carries out preparatory work and analysis in advance of the creation of the permanent FPC.

The interim Financial Policy Committee:Mervyn King, Governor Paul Tucker, Deputy Governor responsible for financial stability Charles Bean, Deputy Governor responsible for monetary stability Hector Sants, Deputy Governor Designate responsible for prudential regulation and CEO of the Financial Services Authority Adair Turner, Chairman of the Financial Services Authority Alastair Clark Michael Cohrs Paul Fisher Andrew Haldane Robert Jenkins Donald Kohn Tom Scholar and Jonathan Taylor have each attended FPC meetings as the Treasury member of the Committee. Martin Wheatley, Managing Director of the Financial Services Authoritys Consumer and Markets Business Unit and CEO Designate of the Financial Conduct Authority, also attends the FPC meetings as an observer.

(1) HMT (2011b).

Foreword by the GovernorThe creation of the Financial Policy Committee (FPC) is a central element of the Governments proposed changes to the system of UK financial regulation. A significant contributory factor to the present financial crisis was the absence of an authority charged with taking actions to mitigate the build-up of risks which could threaten the system as a whole. The FPC will fill that void. The Committees ability to take actions to mitigate systemic risks will hinge on the powers granted to it by Parliament. Without the right instruments at its disposal, the Committee will not be able to take prompt, effective action to tackle emerging risks. To help inform this difficult judgement, the Government, through HM Treasury, requested that the interim FPC make recommendations on the set of statutory macroprudential instruments that the permanent FPC should have at its disposal. The interim Committees formal advice to the Treasury is not due to be published until after the interim Committees March meeting and this paper does not contain the Committees advice. Instead, this paper, which has been produced by staff at the Bank of England and the Financial Services Authority under the guidance of the interim FPC, is intended as a contribution to the debate on appropriate macroprudential tools. As set out in the executive summary and elsewhere, the Committee is actively looking to solicit feedback on the analysis contained in the paper. The FPC has an important job to do. But for it to be a successful body, with the legitimacy to take actions to head off risks to our financial system, it is critical that it engages with interested parties on how macroprudential policy should be formulated and put into effect. This discussion paper is an important part of that process. I look forward to receiving your responses.

December 2011

ContentsBackground information on the FPC Foreword by the Governor Executive summary 1 Introduction 2 3 5 79

Box 1 International developments on macroprudential tools and framework

22.1 2.2

Sources of systemic risk: concepts and evidenceTime-varying risk Cross-sectional risk

1010 14

33.1 3.2 3.3

Potential macroprudential instrumentsBalance sheet tools Tools that influence terms and conditions on new lending Market structure tools

1718 25 26

4 5

Selection criteria Conclusion and next steps

30 31 32 35 37

Annex 1: Indicators of systemic risk Annex 2: Additional macroprudential instruments References

Discussion Paper December 2011


Instruments of macroprudential policyA discussion paper prepared by Bank of England and Financial Services Authority staff.

Executive summaryA growing international consensus is emerging on the need to re-orientate regulatory frameworks to place stronger emphasis on mitigating risks in the financial system as a whole. In June 2011, the Government announced the details of its plans to reform the UK regulatory framework along these lines.(1) A key plank of these proposals is the establishment of a new committee at the Bank of England the Financial Policy Committee (FPC). The FPC will be tasked with monitoring the stability and resilience of the UK financial system and using its powers to tackle those risks. The FPC will have two main powers. The first is a power to make comply or explain recommendations to the new microprudential regulatory authorities, the Prudential Regulation Authority and the Financial Conduct Authority. The second is a power to direct the microprudential authorities to adjust specific macroprudential tools that HM Treasury will set out in secondary legislation. Direction powers are necessary because macroprudential objectives are distinct from microprudential ones. Directions could also be valuable when action is required urgently. HM Treasury has requested that the interim FPC share its analysis and advice on possible Directive macroprudential instruments for public scrutiny and debate. This paper, which has been produced by staff at the Bank of England and the Financial Services Authority under the guidance of the interim FPC, is intended as a contribution to the debate on appropriate macroprudential tools. As outlined in the Record of its September meeting, the Committee has found it useful to partition the set of instruments under consideration into three categories: those that affect the balance sheets of financial institutions; those that affect the terms and conditions of financial transactions; and those that influence market structures.(2) Balance sheet tools include maximum leverage ratios, countercyclical capital and liquidity buffers, time-varying

provisioning practices, and distribution restrictions. These tools influence the level of leverage and maturity mismatch in the financial system. Sectoral capital requirements or variable risk weights could have a role in targeting emerging risks in particular exposure classes. At certain points in the cycle, it may be useful to apply different risk weights to new and old loans to influence the flow of new lending relative to its stock. Tools that influence the terms and conditions of loans and other financial transactions include the ability to restrict the quantity of lending at high loan to value, or high loan to income ratios, and the power to impose and vary minimum margining requirements or haircuts on secured financing and derivative transactions. Market structure tools include obligations to conduct financial trading on organised trading platforms and/or to clear trades through central counterparties. Targeted disclosure requirements could be used to enhance resilience by limiting uncertainty about specific exposures or interconnections. Adjusting risk weights on intra-financial system activities could also play a role in limiting excessive exposures building up between financial institutions. The draft Financial Services Bill requires that FPC Directions be focused on system-wide, rather than firm-specific, characteristics. Directions must also be confined to areas where the United Kingdom has sufficient national discretion; the key hurdle here being that UK regulatory powers in some areas may be constrained by current and forthcoming EU legislation. In its earlier February 2011 consultation paper, HM Treasury outlined an additional criterion: that tools or instruments be specific, rather than broad or open-ended, so that powers of Direction only apply to measures that are defined precisely.(3) The interim FPC has identified a range of additional characteristics that it will have in mind in assessing the relative merits of different instruments for inclusion in the permanent(1) HMT (2011b). (2) Bank of England (2011b). (3) HMT (2011a).


Discussion Paper December 2011

FPCs Directive toolkit. The first is the effectiveness of a tool in mitigating systemic risk. This encompasses both the speed and durability of the effect of the tool and its robustness to regulatory arbitrage and international leakages. Consideration will also need to be given to ensuring the set of tools covers the range of likely systemic risks at all points in the credit cycle. The second is the efficiency with which a tool achieves a given reduction in systemic risk. The FPCs proposed mandate does not authorise it to take actions that may have a significant adverse effect on the capacity of the financial sector to contribute to medium to long-term economic growth. And other things being equal, tools should not put an excessive administrative

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